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Monday, January 31, 2011

Just last week I noted that because of QE2 a real appreciation in China will occur one way or the other: either its currency will appreciate faster or its domestic prices will soar. The former seems unlikely because of China's commitment to its export-driven growth strategy. Consequently, China will most likely stay tied to the Fed's QE2 monetary policy via its crawling peg and continue to allow domestic prices to soar. I also mentioned that this real appreciation should contribute to a rebalancing of the global economy. As if on cue, the New York Times reports the following yesterday:

HONG KONG — Inflation is starting to slow China’s mighty export machine, as buyers from Western multinational companies balk at higher prices and have cut back their planned spring shipments across the Pacific.

Markups of 20 to 50 percent on products like leather shoes and polo shirts have sent Western buyers scrambling for alternate suppliers. But from Vietnam to India, few low-wage developing countries can match China’s manufacturing might — and no country offers refuge from high global commodity prices... The trend, if continued, could ease tensions by beginning to limit America’s huge trade deficit with China.

This is an interesting article throughout, but the one thing it fails to do is connect China's high inflation to the Fed's monetary policy. It is no coincidence that inflation is accelerating now.

Sunday, January 30, 2011

Why should the Fed aim to stabilize total current dollar spending? This figure makes it very clear why: changes in nominal spending get translated largely into changes in real economic activity. Its impact on the price level is far less.

Of course, in an environment where inflation expectations get unanchored, like the 1965-1979 period, nominal spending shocks will have a greater impact on the price level and less influence on real economic activity. And, over the long-run the trend growth rate of the real economy is determined by real factors. But for business cycle considerations, it is hard to argue with a monetary policy goal of stabilizing nominal spending when looking at this figure.

Update: Check out Marcus Nunes who makes an even stronger case using the above figure. He also looks at the 1965-1979 period referenced above. Finally, Marcus provides a nice Beckworth smackdown regarding my use of nominal spending trends.

Friday, January 28, 2011

No, but today's GDP report indicates we are getting closer. Total current dollar spending, as measured by final sales of domestic output, grew an annualized rate of 7.3%. This is fantastic news. We need several more quarters of catch-up growth like this to bring nominal spending back to its trend. Doing so would go along way in making a more robust recovery.

Here is a figure showing the updated final sales along with its 1987-1998 trend. (Click on figure to enlarge).)

As I explain here, I pick this period's trend because it is the part of the Greenspan period where there were no wide, unsustainable swings in economic activity. Moreover, 1998 is when the Greenspan Fed for the first time significantly deviated from past practice by lowering the federal funds rates even though the economy was experiencing robust economic growth. George Kahn provides Taylor Rule evidence that supports this notion.

Update: Bill Woolsey, who prefers a 1984-2007 trend, also takes notice of the acceleration in final sales.

Jon Hilsenrath says the Fed is closer to adopting an explicit inflation target.

Inside the Fed, the idea resurfaced in the fall as the Fed debated the merits of initiating a $600 billion bond-buying program known as quantitative easing. In an Oct. 15 speech in Boston, Mr. Bernanke took another step, saying that Fed officials "generally judge the mandate-consistent inflation rate to be about 2% or a bit below." With inflation running at around 1%, he said there was a case for more Fed easing. An inflation target might be an easier sell when inflation is low; if it were adopted when rates were high, it would be seen as a reason for higher interest rates, which are never popular.

[...]

New challenges this year could put the inflation target back on the agenda. Several Republican lawmakers, concerned that the Fed is stoking inflation, have proposed narrowing the Fed's mandate to price stability, eliminating the employment part.

[...]

The controversial decision to embark on a new round of quantitative easing gave the Fed added reason to adopt a target, Mr. Mishkin says. "In order to make quantitative easing understandable you need to move in this direction of being much clearer about what your long-run inflation objective is and how quantitative easing fits into it," he says. Proponents also say an inflation target goes hand-in-hand with the Fed's employment objective because low inflation supports economic growth and hiring.

I know this is pipe dream, but I wish Fed officials would also consider something like a NGDP level target. Yes, an inflation target would be easier to adopt because it is easier to understand and sell to the public, but it is ladden with problems as I explain here. Interestingly, the Fed did talk about a NGDP target in its September, 2010 FOMC meeting. I actually would prefer an aggregate spending target that stabilized final sales of domestic production rather than NGDP, but I would be happy either way. Should anyone at the Fed care, here, here, and here are some of my recent thoughts on it. Also, here is how I would set the trend for a nominal spending level target.

Thursday, January 27, 2011

Kantoos responds to my earlier question as to whether Germans dislike inflation or bailouts more. He says that this is a difficult question since Germans passionately detest both. What is known, though, is that because of these strong views there is a sort of policy paralysis in Germany that leads to a non-optimal policy outcome:

This would be the worst possible deal for the Eurozone that Germany could have made: The bailouts prolong the crisis without putting the burden, where it should be put: on the bondholders. And yes, these are in part German banks and insurances. The contractionary monetary policy on the other hand forces the periphery in an already suboptimal currency union to adjust even more than what would otherwise have been necessary with an adequate monetary policy.

Sigh. On a lighter note, Merle Hazard has penned a new song about Germany's problems:

The ECB, according to Kantoos and Scott Sumner, is effectively targeting a stable nominal GDP path for Germany. Moreover, it is doing a fine job at it. Kantoos further shows that nominal wage growth is being stabilized around 2% a year. I take that to mean the ECB is not just effectively targeting nominal GDP, but nominal GDP per capita for Germany. This comes close to what I think is an ideal goal for monetary policy for reasons discussed here.

Now while the ECB's monetary policy may be great for Germany it is too tight for the periphery of the Eurozone. Because this one-size-fits-all monetary policy makes it difficult for the the Eurozone to solve its current problems, the European countries seemingly face the tough choice of giving up their currency union experiment or giving up their national sovereignties to make the currency union more functional. Ryan Avent notes, though, that there is a third way to solve this problem: have the ECB loosen monetary policy such that there is a real appreciation in Germany and real depreciation in the Eurozone periphery. I liked his idea and followed up with this:

[H]ere is another option: more monetary easing by the ECB. As Ryan Avent explains, further easing by the ECB would cause a real depreciation for the Eurozone periphery vis-a-vis the Eurozone core:

[T]he key to a relatively painless internal revaluation is inflation in tighter markets. And it's here that the European Central Bank could play a particularly useful role. Were the ECB to adopt a looser monetary policy, we would expect inflation to pick up first in the markets with the least excess capacity, and that would obviously mean rising prices for Germany.

Prices, therefore, would increase more in Germany than in the troubled periphery. Good and services from the periphery would then be relatively cheaper. Thus, even though the exchange rate among them would not change, there would be a relative change in their price levels. This would make the Eurozone periphery more externally competitive. The relative price level change would not be a permanent fix to structural problems facing the Eurozone, but it would provide more time to address the problems.

Of course, this option seems unlikely. My impression is that the one thing Germans hate more than Eurozone bailouts is Eurozone inflation. Any thoughts Kantoos?

Wednesday, January 26, 2011

Late last year I was making arguments like this one about how QE2 would work:

[T]he recovery view begins with notion that a successful QE2 will first raise inflation expectations. The increase in inflation expectations, however, also implies higher expected nominal spending (i.e. higher future nominal spending means higher future inflation). Higher expected nominal spending in an economy with sticky prices and excess capacity should in turn lead to increases in expected real economic growth. Finally, this higher expected real economic growth should increase current real long-term yields. Given the fisher equation, this understanding implies that the rising long-term nominal yields are occurring because of both higher expected inflation and higher real yields.

Thus, contrary to the sales pitch made by Fed officials that QE2 would lower yields, we should expect to see yields ultimately increase if QE2 is successful. Below is an updated figure on the 10-year expected inflation and 10-real treasury yield. (Click on figure to enlarge.)

[Update: the labels on the graph were original reversed and now have been fixed]

To the extent the sustained rise in real yields is reflecting an improved economic outlook, can we not attribute some of that improvement to QE2?

Martin Wolfs reports on the concerns President Hu Jintao of China shared on his recent trip to the United States

“The current international currency system is the product of the past.” Thus did Hu Jintao, China’s president, raise doubts about the role of the US dollar in the global monetary system on the eve of last week’s state visit to Washington. Moreover, he added, “the monetary policy of the United States has a major impact on global liquidity and capital flows and therefore, the liquidity of the US dollar should be kept at a reasonable and stable level.” He is right on both points.

In criticising US fiscal and monetary policies and, in particular, the Federal Reserve’s policy of “quantitative easing”, Mr Hu was following a well-trodden path. In the 1960s, Valéry Giscard d’Estaing, then French finance minister, complained about the dollar’s “exorbitant privilege”. John Connally, US Treasury secretary under Richard Nixon, answered when he described the dollar as “our currency, but your problem”. The French and now the Chinese desire exchange rate stability but detest the inevitable result: an open-ended commitment to buying as many dollars as the US creates.

As Wolf later notes, the obvious solution is for China to stop purchasing dollars and allow its currency to appreciate. China, however, is loathe to do this because it would put a damper on its export-driven growth strategy. As a result, Chinese monetary authorities have to create more yuans to buy up the new QE2 dollars in order to maintain the crawling yuan-dollar peg. The actual and expected increase in yuan, in turn, is contributing to the rise in China's inflation rate. In short, China is importing the Fed's QE2-driven monetary policy. While QE2 may be good for the U.S. economy, it seems a stretch to think its optimal for an economy with 10% annual real growth. Yet the Chinese government continues to allow Fed monetary policy to shape its domestic monetary conditions. So before casting blame, China should remember it can always end this monetary dance with the United States and walk away. After all, it take two to tango.

P.S. If China doesn't walk away from this monetary dance with the United States, then the resulting inflationary pressures will eventually lead to a real appreciation of the yuan that the Chinese government is trying to avoid in the first place. One way or the other, there will ultimately come about a meaningful rebalancing of the global economy.

Tuesday, January 25, 2011

It is highly suggestive of an excess money demand problem. This poll finds that concerns about a "lack of money/low wages" is the most important financial problem American face. This concern trumps healthcare costs and too much debt. Now, the respondents may be thinking more in terms of not having enough income rather than not having enough medium of exchange, but still given all the talk about balance sheet recessions it is interesting that this "lack of money/low wage" concern is more important than too much debt. Here is a summary figure of these concerns since March, 2009: (Click on figure to enlarge.)

Between the findings from this Gallup poll and the data shown in this post, you can forgive me for thinking that maybe, just maybe there still is an excess money demand problem.

Sunday, January 23, 2011

Was the Great Recession of 2007-2009 the result of a large reallocation of workers out of the housing sector after it busted or was it the consequence of a collapse in nominal spending that could have been prevented by policy? Arnold Kling and Bob Murphy have been arguing the former while Scott Sumner and Brad DeLong have been arguing the latter. Here is how Murphy explains the former also known as the "recalculation" view:

[A]fter an unsustainable boom period, the economy needs to "recalculate" and figure out where the excess workers (from the bloated sectors) need to go so that the economy can resume a stable, sustainable growth... Kling (and the Austrians) are arguing that this recession is not simply about a lack of generic "spending" but rather is tied to the preceding housing boom. In particular, during the boom, workers were sucked into construction (and other related occupations). Once the housing bubble collapsed, these excess workers needed to go someplace else. That's why unemployment started rising, and "the recession" set in.

Scott Sumner responded to this claim by nothing that though this understanding seems reasonable--it was the greatest housing boom after all--it is not supported by the data. The housing boom peaked in early 2006 and yet the Great Recession does not really start to get going until mid-to-late 2008, when policymakers allow aggregate spending to collapse. Thus, the housing bust at best would have led to a mild recession. It was the failure of monetary policy that created the Great Recession.

Murphy replied to Sumner by asking him to consider construction employment. He argued that by plotting construction data along with the unemployment rate one can actually see a recalculation story in the data. His figure, though, was not very convincing as it revealed that the unemployment rate does not start its pronounced climb until about May 2008 whereas construction employment begins its nose dive back in May 2007. Thus, unemployment was relatively stable about a year after construction employment began plummeting. This is more consistent with Sumner's story.

As is well known, though, the unemployment rate is not always the best measure of labor markets so I decided to look at other relevant employment data. I did so using Sumner's story that monetary policy effectively tightened in 2008 as a benchmark point. This effective tightening of monetary policy can bee seen by looking at monthly nominal GDP.The idea here is that if the Fed allows total current dollar spending to fall, even passively through say an unchecked decrease in velocity, then monetary policy is effectively tightening. With this understanding, the figure below, indicates that monetary policy effectively tightened in June, 2008 and did not start easing until June 2009. Therefore, monetary policy was tight even before the big blow up on Wall Street in late 2008. (Click on figure to enlarge.)

So let's look at construction employment again prior to the effective tightening of monetary policy in June 2008. And now, let's compare it to the number of layoffs and discharges measured by the BLS' Job Opening and Labor Turnover Survey. The figure below shows these two series with the April, 2006 peak in construction employment indicated by the dashed line. Both scales are in thousands. (Click on figure to enlarge.)

Contrary to the recalculation view, there is no evidence of the peaking and subsequent fall in construction employment making a meaningful increase in the number of layoffs and discharges before June, 2008. The fall in construction employment, therefore, must have been offset by employment growth in other sectors. This interpretation is borne out in the figure below. It shows total employment less construction employment graphed along side construction employment. (Click on figure to enlarge.)

This figure shows that through April, 2008 non-construction employment in rising (and it only significantly starts declining in June, 2008). This, despite the fact that construction employment had been rapidly dropping from May, 2007 and had stalled out back in April, 2006. In other words, the rest of the economy was doing a decent job absorbing the displaced construction workers for over a year. No reallocation story here. Chalk one up for Scott Sumner.

Scott Sumner's case, however, gets even stronger if we look beyond mid-2008 and compare it to the growth rate of nominal spending. The figure below shows layoff and discharges again, but now it is graphed against the growth rate of monthly nominal GDP. Now we see there is a surge in layoffs and discharges but it coincides with the collapse in the nominal GDP growth rate. (Click on figure to enlarge.)

The data seems very clear to me. It indicates there was a housing bust that was putting a damper on economic activity, but by itself was not large enough to create the Great Recession of 2007-2009. Rather, that required the failure of Fed officials to stabilize nominal spending in 2008.

Friday, January 21, 2011

In the past I said yes, now I say no. The reason being is that there is something more fundamental going on than household balance sheets being a mess. To see the real problem, consider the standard story told as to why weakened household balance sheets pose such a problem to a robust economic recovery. Here is how Ryan Avent tells it:

In the years prior to the crisis, households accumulated a lot of debt, which was offset by rising asset prices. Those asset prices then collapsed and many households are now desperately attempting to pay down their debts. Because they're heavily indebted, efforts to spark a recovery by encouraging household spending or residential investments are likely to go nowhere; people are simply too broke.

Households have no choice but to set aside part of their income to both rebuild the asset side of the balance sheet and to pay down their debts. This is one of the main reasons why recovery from these “balance sheet recessions” is notoriously slow. As households rebuild their balance sheets, resources are directed away from consumption, and the reduction in aggregate demand is a drag on the economy.

Note that the hindrance to a full recovery in this balance sheet recession story is the increased saving being done to repair the balance sheets. But this begs the question, why aren't the creditors who are receiving the increased payments spending the money? If they were, then aggregate nominal spending would not be disrupted. The problem, then, is not that balance sheets are a mess but that creditors are not providing offsetting spending. Because creditors are holding on to the money payments from debtors, what we fundamentally have is an excess money demand problem. Here is how I explained this problem elsewhere:

[The balance sheet recession view] fails to recognize that for every debtor there must be a creditor. Thus, for every debtor who is cutting back on spending in order to pay off his debts, there is a creditor receiving money payments. In principle, these creditors should be increasing their money spending to offset the decline in money spending by the debtors — but if that were happening, there would have been no decline in overall total current-dollar spending. Instead, creditors are sitting on their money because they see an uncertain economic future. Creditor households are reluctant to buy new cars or get their kitchens remodeled lest they lose their jobs in the future. Creditor firms, meanwhile, are reluctant to build new plants since they cannot see how they would be able to sell all the new production coming from those plants. Similarly, creditor banks are not increasing lending as there is little demand for funds and few creditworthy borrowers.

If these creditor households, firms, and banks all simultaneously started spending their excess money balances, this would increase total current-dollar spending and in turn spur a real economic recovery. Moreover, knowing that the real economy would improve would feed back and reinforce current spending decisions by the creditors — creditor households would buy new cars and remodel their kitchens, creditor firms would build new plants, and creditor banks would increase lending. A virtuous cycle would take hold and push the economy back toward full employment. But this virtuous cycle is not taking off because creditors are still hanging on to their money balances. What is needed to kickstart this cycle is an entity powerful enough to incentivize all the creditor households and firms to start spending their money simultaneously.

Enter the Federal Reserve. It alone has the ability to provide these incentives through its control of monetary policy. The fact that total current-dollar spending has remained depressed for so long means that the Federal Reserve has failed to do its job and effectively has kept monetary policy too tight.

The solution, then, is for the Fed to use monetary policy to change nominal expectations in a way that solves the excess money demand problem. Here is how I would have the Fed do it.

Wednesday, January 19, 2011

Is it really that hard for monetary policy restore total current dollar spending to trend? As an advocate of nominal GDP level targeting, I certainly believe the Fed is capable of such a task and have been makingthecase for sometime. Skeptics, however, typically throw out some version of the Fed "pushing on a string" argument as a rebuttal. While appealing, this view ignores the best data point we have on this question: the Great Depression. As is well known, nominal spending fell in half during this time and slowly recovered during the decade. As is also well known, FDR's monetary easing--devaluing the gold content of dollar and not sterilizing gold inflows--and the nominal expectations it created were key to restoring nominal spending. The recovery path was not perfect, but eventually total current dollar spending returned to its pre-Great Depression trend as seen in the figure below:

This is a remarkable accomplishment given the dire circumstances of the 1930s. Note that full employment was restored without the unleashing of hyperinflation or any of the other concerns raised by critics of monetary stimulus. So why can't the same happen today? Why is it that instead of having a figure like the one above where nominal spending returns to trend we instead get the following one?

Tuesday, January 18, 2011

Well, at least Bob Murphy does over at Mises.org. He attempts to tear apart the case I made for QE2 in the National Review Online. Strangely, his blistering attack never once addresses the key point of my argument: QE2 is an imperfect attempt to address the on-going excess money demand problem. He commits a host of mischaracterizations about my article that all stem from his avoidance of this issue. My takeaway from the piece is that Bob Murphy does not take seriously monetary disequilibrium. If Bob Murphy wanted to do a reasonable critique of my piece, then he should have questioned whether there really is an on-going excess money demand problem as I claim. Instead his piece amounts to anti-Keynesian rant where among other things he labels me a "Monetarist-Keynesian." Come on, everyone knows that I along with Scott Sumner, Nick Rowe, Bill Woosley and Josh Hendrickson are known around the economic blogosphere as Quasi-Monetarists!

Fortunately, Jeffrey Tucker of the Mises Institute has agreed to publish my reply where I attempt to explain to the Mises.org readers the importance of monetary disequilibrium and in particular the excess money demand problem. [Update: my reply has been published here.] In the meantime, interested readers can go check out the replies to Bob Murphy's article from Josh Hendrickson and Bill Woolsey. They both do an excellent job explaining the monetary disequilibrium view.

P.S. I did get a chuckle out of the picture of me constructed by the folks at Mises.org. It was very clever.

Monday, January 17, 2011

Tim Duy and Andy Harless call me out for being critical of the the Fed's low interest rates in the early-to-mid 2000s and for being critical of the Fed for failing to stabilize total current dollar spending. They say I cannot have it both ways. They argue that in order to keep nominal spending stable in the early-to-mid 2000s, the Fed had to push the federal funds rate below its neutral rate level for an extended period. Therefore, it is unfair for me to assign blame to the Fed for the credit and housing boom. Scott Sumner and Bill Woolsey have also raised this question to me in the past. So what do we make of it? I am being inconsistent?

Though it may not convince everyone, there is a way to reconcile my two criticisms of the Fed. The key to doing so is appropriately specifying the trend growth of nominal spending. I will define it here as the trend growth rate over the 1987-1998 period for several reasons. First, its the part of the Greenspan period where there were no wide, unsustainable swings in economic activity. Second, 1998 is when the Greenspan Fed for the first time significantly deviated from past practice by lowering the federal funds rates even though the economy was experiencing robust economic growth. (Robert Hetzel argues in his book that the easing actually started in 1997 when the Fed failed to raise interest rates. See his chapter 16, Departing from the Standard Procedures.) The reasons for the easing were concerns that the global economic turmoil would spill over into the U.S. economy.

With this trend, I now look to see how nominal spending has subsequently fared using two different measures in the figures below. The first figure shows domestic total current dollar spending. This is the narrower of the two measures of nominal spending since it leaves out foreign spending on the U.S. economy. However, it is appropriate for looking at spending by U.S. residents: (Click on figure to enlarge.)

This figure reveals that there were two above-trend surges in nominal spending, one at the end of the 1990s and the other during the credit and housing boom. The first nominal spending boom is consistent with the tech-bubble and the Fed's easing in the late 1990s. Interestingly, the 2001 recession simply returns nominal spending to trend. The second boom is the one in question and is much larger. Note, that despite this boom nominal spending is now below trend and is increasingly moving away from it. Thus, the Fed has failed to restore trend level nominal spending. This failure amounts to monetary tightening. QE2 is simply an imperfect attempt to bring the U.S. economy back to the trend.

The next figure shows all nominal spending on the U.S. economy, including that of foreigners. This figure shows a similar picture though the nominal spending booms are little larger. (Click on figure to enlarge.)

The monetary tightening is less pronounced in this figure, but it is still there. Both figures imply there needs to be several periods of catch up nominal spending growth. Both figures also imply that the Fed allowed nominal spending to grow too fast in the early-to-mid 2000s. Returning current dollar spending to trend would be much easier if the Fed would commit to an explicit nominal spending rule that would help shape expectations.

Friday, January 14, 2011

With the release of the 2005 FOMC transcripts we learn that the Fed was aware of the housing boom but failed to alter monetary policy. Among other damning evidence, we find this gem in the December 2005 FOMC meeting. It shows the real federal funds rate compared to the Fed's estimate of the equilrium or neutral real federal funds. There is a striking gap that emerges during the early-to-mid 2000s. This indicates the Fed was highly accommodative and aware of it. This monetary ease was an important contributor to to the credit and housing boom for reasons explained here and here.

So much for Alan Greenspan's challenge for someone to "prove him wrong" in his leadership of the Fed. As Yves Smith notes, what makes these and other revelations about this period particularly frustrating is that the Fed continues to shirk blame for the crisis.

One goal of QE2 is to raise inflation expectations. According to the latest Cleveland Fed data on expected inflation, QE2 is doing just that: (Click on figure to enlarge.)

Though far from perfect, QE2 should be considered successful on this objective. Raising inflation expectations is important for two complementary reasons.

First, absent any negative productivity shock, higher expected inflation indicates the Fed is also raising expectations of future total dollar spending (that is how the prices will rise). Higher nominal spending, in turn, means the real economy should be improving too, given sticky prices and excess economic capacity. Such an improved economic outlook will cause households and firms to increase current spending.

Second, higher expected inflation also increases the opportunity cost of holding low-yielding liquid assets like money and treasuries. This will encourage folks to adjust their portfolios away from money and treasuries to higher yielding assets. This portfolio rebalancing will shore up stocks, real estate, and other equity-type assets. This rise in asset prices, in turn, will improve balance sheets making it easier to for household and firms to spend. This is an important issue given the unusually large share of liquid assets being held by these sectors.

Thursday, January 13, 2011

Scott Sumner directs us to a Financial Times piece that claims the Bank of England is secretly targeting a nominal GDP growth rate of 5%. As a proponent of nominal GDP targeting, I was intrigued and wanted to see if the UK data supported this claim. So I created the figure below using the IMF's IFS database. It shows the natural log of UK nominal GDP data for the 1990:Q1-2010:Q3 along with a fitted trend for the 1990:Q1-2007:Q4 period. (Click on figure to enlarge.)

This slope of the trend line indicates an average nominal GDP growth rate of 5.3%. It seems plausible, then, that the Bank of England is actually targeting nominal GDP. This is not entirely surprising given there are respected economic commentators in the UK like Martin Wolf and Samuel Brittan that endorse the idea. Of course, it would be even better if the Bank of England were targeting the nominal GDP level and thus aimed to close the NGDP gap in the figure above. However, given the grief the Bank of England is getting for its current monetary policies a level target seems unlikely.

Here, here, and here are a few of my most posts that explain why I like nominal GDP targeting.

Wednesday, January 12, 2011

Chinese inflation is running consistently higher than American inflation, which is scarcely above 1%. That translates into rapid real appreciation despite the slow movement in the nominal exchange rate. And that should produce a decline in Sino-American imbalances, which seems to be emerging.

Ryan Avent can correct me if I am wrong, but I suspect some of that run up in Chinese inflation is the result of QE2. Chinese monetary authorities are forced to create more yuans to buy up the new QE2 dollars in order to maintain the crawling yuan-dollar peg. The actual and expected increase in yuan, in turn, is contributing to the rise in China's inflation rate. In short, China is importing the Fed's QE2-driven monetary policy. If this real appreciation actually leads to meaningful rebalancing in the global economy, then QE2 may be what ends Bretton Woods 2.

Randall W. Forsyth points to two recent developments as part of a broader change in the global monetary system:

The new world monetary order continued to evolve with two separate developments Tuesday. Japan said it would join China in buying debt securities to support beleaguered European sovereign creditors. In so doing, the world's No. 2 and No. 3 economies were acting to try to hold together the euro as a viable alternative to the world's reserve currency, the dollar, from the No. 1 economy, the U.S. At the same time, China permitted trading of the renminbi in the U.S. for the first time -- a significant step in the RMB becoming a full-fledged international, convertible currency...[These two developments] are both part of the loosening of the global monetary system away from its dollar-centric mooring.

Maybe so, but there there are many hurdles for alternative currencies to clear before there arises any meaningful threat to the dollar's reserve status. Just look at the dominance of the dollar in the global forex market over the past three years. Even when this change in the globlal monetary system does come about, Barry Eichengreen believes the dollar will still be a dominant currency in the global economy. For better or for worse, then, the Federal Reserve will continue to be a monetary superpower for some time.

Tuesday, January 11, 2011

It has taken a beating lately from Paul Krugman. First, he says the Texas economy is not so special in terms of handling the recession. He makes this claim based on a comparison of the unemployment rate in Texas with that of New York. Second, he notes its budget problems are well, Texas-sized with a $25 billion budget hole. Thus, he concludes its conservative-based polices are not a model for other states to follow. Are his critiques valid?

On the fist point, Ryan Avent points out that Krugman's use of the unemployment rate is misleading because there has been a large migration to Texas where there has been hardly any to New York. Thus, a significant part of the unemployment rate in Texas during the recession comes from there being so many newcomers while that is not the case in New York.

Further evidence undermining Krugman's first critique can be seen in the following figure. It shows that the employment growth rate has been far stronger in Texas than New York in 2010. (Click on figure to enlarge.)

On the second point, Kevin D. Williamson notes that Krugman vastly overstates the Texas' budget problems. First, the real budget shortfall is probably going to be $11-$15 billion, not $25 billlion. Second, Texas actually has a $10 billion dollar rainy-day fund that could cover much of the budget hole if necessary. Thus, Texas is not going to have a budget shortfall.

Of course, New York is just one of 49 other states. Why not compare Texas to the California, the other big state? Oh yea, that has already been done and it makes Texas look special.

Now all of this does not mean Texas is the model for the rest of the states to follow. Some of its good fortune is idiosyncratic--oil prices and migration--as noted by Ryan Avent. Some of its success its policy driven too. It does mean, though, that this mix of indiosyncratic developments and policies works well for Texas. And for that I, a resident of Texas, am grateful.

The answer is no for most of us. If, on the other hand, you live inside a Florida prison then the answer is yes. For the economies inside Florida prisons now use honey buns as a medium of exchange. And as Nick Rowe has tirelessly explained, recessions can only occur when there is an excess demand for the medium of exchange. I am not sure, though, what a prison economy recession would look like...

Why do we continue to get the following line of reasoning about QE2 and interest rates reported in the press?

The trouble [with QE2] is, though yields fell sharply between August and November as the markets anticipated the new program, they have risen since it was formally announced in November, leaving many in the markets puzzled about the value of the Fed’s bond-buying program.

This particular quote comes from the New York Times, but it is ubiquitous in the press. As I and others have said before, a truly successful QE2--one that helps revive the economy--should ultimately lead to higher bond interest rates. Yes, yields may initially fall but an economic recovery should be accompanied by rise in interest rates as the demand for credit increases. Amazingly, after spending several paragraphs raising doubts about whether QE2 is working because of rising yields, the NY Times article closes with this from Brian P. Sack, the head of the NY Fed trading desk:

“Rates have risen for the reasons we were hoping for: investors are more optimistic about the recovery,” said Mr. Sack. “It is a good sign.”

And they save that for the closer? How much more insightful the article could have been had there been some discussion about this point up front. QE2 is far from perfect, but it is probably in some way contributing to the change in economic expectations and thus the uptick in interest rates. It is that simple.

There is a certain mayor in South Carolina who just happens to know a lot about monetary economics. In fact, he has critically weighed in on some of my posts and helped sharpen my thinking on monetary economics. Unlike many macroeconomists, he takes money seriously and understands the importance of monetary disequilibrium. This is not terribly surprising as he is the former student of Leland Yeager. This mayor is Bill Woolsey.

He has his own blog and provides thoughtful posts on monetary issues. For example, he recently considered the claim by Brad DeLong that it is liquidity demand shocks rather than money demand shocks that cause recessions. I bring this up because how many politicians do you know that have such mastery over such an important issue as monetary policy? And based on these twonews stories he is an effective mayor too. Maybe one day Mayor Woolsey will consider running for Congress. It would be great to have such a monetary-minded congressman.

Friday, January 7, 2011

Another sign of the dwindling fortunes of the eurozone emerged this week. The economies of western Europe overtook their neighbours in central and eastern Europe as greater default risks....An index that measures the risk of default of 15 western European economies, including Germany, France and the peripheral eurozone countries, has surged higher than a comparable one comprised of countries such as Hungary and Ukraine. These indices, which measure the cost to insure the two geographical groups against default, suggest any hopes that the festive lull could give the eurozone a breathing space appear to be fading, only one week into the new year.

The article explains the key reason for the change is both the ongoing deterioration of the Eurozone periphery and the improving lot of Eastern European countries like Hungary, Ukraine, and Poland. The Euro itself has been a big contributor to this mess. Its existence meant applying a one-size-fits-all monetary policy to vastly different economies. Because the largest two economies in the Eurozone, Germany and France, made up about half of the overall the Eurozone economy, it is not surprising that developments in these countries largely shaped the evolution of the one-size-fits-all approach to monetary policy. Thus, in the early 2000s monetary policy in the Eurozone was appropriate for the core countries but too loose for the periphery. Lately, Eurozone monetary policy has been too tight for the periphery while about right for the core.

Wednesday, January 5, 2011

Here is a quiz for all the hard-money advocates of the world: what common message do the following three figures tell us?

The first figure shows for the combined balance sheets of households, non-profits, corporations, and non-corporate businesses the percent of total asset that are liquid ones. The traditional money assets include cash, checking accounts, saving and time deposits, and money market funds. The figure is created using the flow of funds data. Note the sudden and sustained spike in the liquid share over the past few years: (Click on figure to enlarge.)

The second figure shows the velocity of various money measures. Note that all velocity measures have fallen and remain well below pre-crisis levels: (Click on figure to enlarge.)

The third and final figure shows the level of total current dollar spending per capita. Note here that nominal spending per person as of the 2010:Q3 is where it was in 2007:Q2: (Click on figure to enlarge.)

Tyler Cowen recently raised the question of whether the Fed could have actually implemented Scott Sumner's plan for a nominal GDP target during the crisis:

Let's say that at the peak of a financial crisis, the central bank announces a firm intention to target a path or a level of nominal GDP, as Scott suggests. If everyone is scrambling for liquidity, and panic is present or recent, and M2 is falling, I wonder if the central bank's announcement will be much heeded. The announcement simply isn't very focal, relative to the panic

Here are my thoughts on the matter. First, an important premise of this debate is that a credible NGDP level target would anchor growth expectations of total current dollar spending around a target growth path. The stabilization of such expectations in turn would keep current nominal spending close to its target growth and make it less susceptible to negative economic shocks, like the housing and financial shocks of 2008. This is an important point. Fluctuations in NGDP get transmitted either to real GDP growth or price level growth or both. However, because prices do not adjust instantly, NGDP shocks have largely been transmitted to real GDP as can be seen in the figure below. Thus, a credible NGDP level target that stabilize NGDP growth expectations would go a long ways in stabilizing the real economy too.(Click on figure to enlarge.)

Second, from a NGDP targeting perspective any below trend decline in NGDP amounts to an effective tightening of monetary policy. Thus, even if the Fed has done nothing but velocity falls then monetary policy is effectively tightening. To prevent such tightening the Fed needs to respond to fall in velocity with additional monetary stimulus. With this understanding, the figure below, which shows monthly nominal GDP, indicates that monetary policy effectively tightened in June, 2008 and did not start easing until June 2009. Therefore, monetary policy was tight even before the big blow up on Wall Street in late 2008. (Click on figure to enlarge.)

Surely this tightening of monetary policy in mid-2008 made the financial system more vulnerable to shocks later in the year. Moreover, it is possible the shocks themselves may have been smaller had monetary policy been looser. There probably would have been a recession no matter what, but it would have been far milder had the Fed been explicitly stabilizing NGDP.

Third, the experience of unconventional monetary policy starting in mid-1933 suggests that Fed could have done something to avert the collapse on nominal spending in late 2008-early 2009. The U.S. economy had been collapsing for close to three years when FDR began his own unconventional monetary policy in 1933. As shown by Gautti Eggerton and others, FDR's policies radically changed expectations at a time when deflationary expectations seem set. Adopting a NGDP target in late 2008 or early 2009 may have been the radical equivalent of FDR's money policies in the 1930s. Had the Fed adopted a NGDP target and marketed it with a massive PR campaign it seems plausible that nominal spending expectations could have been stabilized a lot sooner. Why would it have been any more challenging to make a NGDP level target work in late 2008-early 2009 than for FDR to make unconventional monetary policy work in 1933?The way I see it, the question is not whether a NGDP level target could have worked. The real question is why the Fed did not try something more radical like a NGDP or price level target. For more on Tyler Cowen's question see Scott Sumner and Ryan Avent.

By chance I came across two articles today that are wildly optimistic about global economic growth in the future. First, via Karl Smith I see that Robin Hanson is talking up the possibility of a robot-induced "singularity" in the future that will radically increase global economic growth rates. Second, Ambrose Evans-Pritchard is highlighting an HSBC report that foresees a pronounced increased in the trend global economic growth by 2050.

These two pieces are both interesting but ignore an important question: what type of monetary policy arrangement would be most conducive to maintaining economic stability during such rapid economic growth? Such an environment could easily lead to overoptimism that in turn could fuel an unsustainable asset and credit boom. It is easy to see how monetary policy could play into such an unsustainable boom. The rapid productivity gains implied by these two pieces would create strong deflationary pressures. Central banks targeting some form of price stability would react by adding monetary stimulus to prevent deflation from emerging. But adding monetary stimulus in the midst of such a boom would only intensify it. Another way of seeing this is to realize that a productivity boom typically puts upward pressure on the neutral real interest rate. Trying to maintain price stability in face of productivity boom, however, requires central banks to lower the real interest rate.

So is there a monetary policy that could handle such rapid economic growth without destabilizing it? Fortunately, George Selgin has thought extensively about this very situation and has come up with what he calls the Productivity Norm Rule for monetary policy. This monetary policy rule would have have nominal GDP grow at the same rate as that of factor inputs. Doing so would allow productivity gains to be reflected in the price level while maintaining factor price stability. Thus, the Productivity Norm in an environment of rapid productivity growth would tend to stabilize nominal wages, allow the price level to decline, and yet keep aggregate spending growth stable. Selgin has nicely articulated the details and implications of the Productivity Norm Rule in his monograph titled "Less Than Zero." If, in fact, Robin Hanson and HSBC are correct in their assessment of future economic growth, then Selgin's monograph should become required reading for every central banker.